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LNG execs looking for a scapegoat

David Llewellyn-Smith

It's been difficult to miss the growing anxiety expressed by Australia's senior oil and gas executives over the past few weeks. To just about a man they have released extraordinary cost blowouts and aimed serious criticism at Australia's industrial relations system. There is more today from Michael Chaney, chairman of National Australia Bank and Woodside Petroleum.

Australia is likely to fall off a "growth cliff" when the resources investment boom ends in the next few years because the economy is not becoming more productive, Mr Chaney says.

Economic growth was likely to slow to less than 2.5 per cent after 2015 because of burdens on business, including overlapping state and federal environmental regulations, and Labor's industrial relations system, which made the workplace less flexible, along with other problems, he said.

David Knox, CEO of Santos, chimed in with similar arguments today. There is no doubt that labour costs have soared as Australia undertook 70 per cent of the world's liquefied natural gas capacity building in the past few years. But labour is only a serious issue during construction. For decades afterwards, labour inputs fall, a lot. And although the executive refrain about labour costs is absolutely right, it is, in fact, the tip of the iceberg when it comes to the growing challenges confronting Australian LNG.

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A more fundamental challenge to the boom is a medium term global gas glut that is set to drive down LNG prices and margins. The assumptions of the current Australian LNG boom were based upon boomtime extrapolations. They overpaid for assets, are overpaying to build all at once and have assumed too high a price and return. The dollar is higher for longer than anyone expected and the unconventional gas boom is extraordinary everywhere but especially so in the United States, which aims to export to Asia. In short, Australian LNG, like Australian iron ore and coal producers, underestimated capitalism.

Despite owning a wealth of energy supplies in the Asian century, the simple economics of supply, demand and price can dash even the most grounded projections. The Australian Bureau of Resources and Energy Economics estimates that in the 2016-17 financial year the value of Australia's LNG exports will reach $26 billion in current dollar terms against $11 billion in 2010-11. This forecast largely arises from volume projections rising from 20 million tonnes in 2010-11 to 63 million tonnes.

These enormous, capital intensive projects, ranging from Ichthys near Darwin to Curtis and Gladstone in Queensland to Gorgon and Pluto off Western Australia, have come about thanks to Australia's excellent sovereign risk credentials, proximity to Asia and significant reserves.

Having supplied Japan for almost 25 years with reliable LNG it's unsurprising that Australia has received so much foreign investment, yet at the same time – and especially considering Japan's inordinate reliance on gas since Fukushima – high costs are beginning to bear.

Ichthys, which is set to supply 70 per cent of production to Japanese power companies, is presently costing $US4b ($A3.85b)per million tonnes of annual capacity versus $US1.7b/Mt for a similar project in Angola. Further, Japan currently imports gas at around $US12-$13 per million British thermal units (Mbtu) versus the benchmark Henry Hub gas price of $3-$5.

Currently gas is a market that's largely determined on a contract basis and thus it tends not to be fungible. Historically, suppliers and buyers would hammer out long-term contracts – the pipeline deals between the Soviets and Western Europe is a classic example – to underwrite the huge costs of transmission and to ensure a stable supply. Yet the very thing that made Australia a burgeoning gas supplier – LNG technology that allowed gas to be transported by ship in liquid form – heralds this system's rapid demise.

Japan has been keeping the heat on all LNG suppliers to break the oil-benchmark contract system, recently accosting Qatar at the inaugural LNG Producer-Consumer Conference. There is also an increasing push by firms in Europe to renegotiate long-term LNG supply contracts away from oil benchmarks, with some success. The Australian pipeline of LNG projects is underpinned by these same oil-linked long-term contracts. But most also have price revision provisions in the event that gas prices tumble.

US gas supplies are the swing factor in this market flux. Shale gas, which has risen from 2% to 37% of total US natural gas production since 2005, poses the biggest threat to Australia's export competitiveness and the completion of the current investment in LNG infrastructure. No fewer than 10 US projects have applied to the US Department of Energy for the right to export LNG to Asia, with a total potential capacity well above 100Mt. Given that Australia's projected 2017 expanded supply potential is less than one third of that, you start to see why Japanese and other north Asian clients are now reconsidering their commitment to long-term contracts as the primary pricing mechanism for seaborne LNG. So much so, in fact, that BHP itself, the "Big Australian", is considering further investment in that market. Australian projects are underpinned by this contract system but some have renegotiation provisions in the event that prices fall.

It's no wonder that Australian LNG executives are looking for a scapegoat.

David Llewellyn-Smith is the editor of Macro Investor, Australia's leading independent investment newsletter covering stocks, trades, fixed interest and property. This week, Macro Investor offers a special edition on the prospects for the oil and gas sector. A free 21-day trial is available.